Existing trading exchanges for debt and equity securities rely on open-market forces to efficiently and reliably match buyers and sellers of financial securities. These exchanges may incorporate a traditional trading floor where participants gather at a common location to negotiate the buying and selling of financial instruments. More recently, Internet-based technology has enabled electronic exchanges to facilitate the trading of financial instruments, absent a brick-and-mortar trading floor. In some cases, a combination of face-to-face trading occurs in conjunction with remote electronic trading, as in well-known exchanges such as the New York Stock Exchange. Regardless of the forum, trade in a wide variety of financial instruments feeds the activities of exchanges throughout the world.
With respect to debt instruments, most exchange-based trading occurs in securitized debt such as bonds, T-bills, commercial paper and so on. Cash instruments, such as loans, are usually traded in the secondary market as pools of loans, rather than individual loans. For example, large institutional investors, such as Freddie Mac, buy closed mortgage loans in pools. The pools may then be securitized and sold to other investors as mortgage-backed securities.
However, such loan pools do not address the risk of individual closed loans. Loan pools group individual loans that may have similar risk characteristics, but the pool itself is sold as a single investment, with a single average risk characteristic, leaving little or no transparency as to the risk of the individual loans within the pool. As a result, an investor is unable to screen individual loans and make purchasing decisions based on the risk-level of an individual loan. Furthermore, individual closed loans tend to be illiquid trading instruments. Not surprisingly then, most buying and selling of closed loans is accomplished through private deals between buyers and sellers.
Until recently, the availability of loan pools in individual closed loans through established trading platforms and private networks served the needs of the industry. However, with delinquency and default rates suddenly rising, investors previously content with trading in loan pools no longer can tolerate their hidden risks.
When interest rates were at all-time lows, subprime lenders made loans to borrowers with poor credit histories. Many of these loans ended up in loan pools in the secondary market, where the individual risk of such loans are often masked by the overall average risk of the loan pool and aided by the inaccessibility of loan-file details. The market value of many of these loans now lies below face value, which has created a subprime crisis, and forced many large lenders and investors to close or file bankruptcy.
Many investors previously content with purchasing loans in the aggregate now recognize the need to scrutinize their debt instrument investments on a loan-by-loan basis, possibly building their own loan pools through individual purchases. However, existing trade exchanges are not structured to support such transactions, nor can limited private networks efficiently accommodate the new demand. Therefore, there exists a need in the financial industry for an efficient trading system to facilitate the buying and selling of individual closed loans, especially closed residential mortgage loans.